Is It Safe To Invest In BP plc And Royal Dutch Shell Plc While Oil Remains Above $100?

Are oil prices above $100 the new normal? For investors in BP (LSE: BP) (NYSE: BP.US) and Royal Dutch Shell (LSE: RDSB) (NYSE: RDS-B.US), it’s a key question, but the answer is far from clear.

bpBP published its annual Statistical Review this week, highlighting the fact that 2013 was the third consecutive year during which oil prices remained above $100 per barrel. Christof Rühl, BP’s Group Chief Economist, says that the oil market has not been this stable since the 1970s — but describes the apparent stability as “sheer coincidence”.

It’s a coincidence, because disruptions to oil supply, mainly in the Middle East and North Africa, have totalled nearly 3 million barrels per day (bopd) over the last three years. However, these have been offset almost exactly by growth in the US oil industry, where production rose by 1.1m bopd in 2013 alone.

Obviously this finely balanced situation will not continue indefinitely — eventually, supply and demand will fall out of balance, and volatility will return to the oil market.

Are shareholders safe?

Historically, oil prices have only been this high twice before; in the late 1970s, and, briefly, in 2008. Both peaks were followed by sharp falls.

What would happen to BP and Shell’s profits if the average price of oil fell — perhaps to $85?

  BP Shell
Total liquids production, 2013 429.2m barrels 562.5m barrels
Liquid sales, 2013 actual prices $42.6bn ($99.24/bbl) $56.5bn ($100.42/bbl)
2013 sales at $85/barrel $36.5bn $47.8bn
Estimated pre-tax loss $6.1bn $8.7bn
2013 pre-tax profits $23.8bn $33.6bn

Source: Company reports.

I’m not worrying (x3)

Firstly, these numbers suggest to me that while it might be slightly uncomfortable, neither BP nor Shell would have any problems operating profitably if oil prices fell to $85 per barrel.

If lower prices persisted for more than a year, dividends might come under pressure, but both Shell and BP both have very low levels of debt, and could afford to fund their dividends through an occasional weak year for oil profits.

Secondly, both companies have a growing focus on natural gas. Shell sold $20bn of natural gas in 2013, while BP sold gas worth $12.2bn. Both totals are likely to continue to rise: for example, BP has just announced a 20 year, $20bn contract to supply liquefied natural gas to China.

Finally, a significant amount of global oil production would become unprofitable at prices much below $85, meaning that if prices fell too far, supply would naturally become restricted, pushing prices back up again. Shell and BP’s scale and balanced portfolios mean they would probably survive such an experience unscathed: smaller, higher-cost producers, with high gearing would be the first to fail.

Where next for profits?

BP and Shell still look cheap to me, but neither firm was sufficiently attractive to earn a place in the Motley Fool's latest special report, "Where We Believe The Smart Money Is Going Today".

In this brand-new report, the Fool's top analysts highlight some of the opportunities they've spotted recently. Given that the team's picks are up by an average of 28% in two years, I believe you should take a closer look.

This report is completely FREE and without obligation. To receive your copy today, simply click here now.

> Roland owns shares in Royal Dutch Shell but does not own shares in any of the other companies mentioned in this article.